This article can be found in the New York Law Journal‘s Corporate Restructuring and Bankruptcy special report.

Amidst the sometimes dramatic fluctuations in commodity prices that buffet the oil and gas industry, investors generally relied on one segment of the market to be safe and stable: so-called “midstream” companies that own the pipelines that transport oil and gas. The rationale was that the oil and gas had to travel, and the fare had to be paid, regardless of the commodity price – not to mention that “take or pay” contracts were the norm in the industry. Investors’ perception of the safety of investments in midstream companies – i.e. the owners of the pipelines – was shaken by a March 2016 decision out of the Southern District of New York Bankruptcy Court permitting a bankrupt oil exploration company to reject its midstream service contracts. In re Sabine Oil & Gas Corp., (No. 15-11835 SCC) (Bankr. S.D.N.Y. March 8, 2016, ECF No. 872) (“Sabine”). Sabine set the stage for several heated battles over a debtor’s ability to reject midstream contracts, and, in the process, introduced concern regarding midstream companies’ cash flows. These conflicts arise at the intersection of the core bankruptcy tool of contract rejection, centuries-old state property law, and how the financing that supported the recent expansion of domestic oil and gas production was structured.

This article discusses the details of these conflicts and how the parties have achieved either resolution or the ability to move on despite the continuing lack of definitive answers in every case.

There is at least one thing that both President-Elect Donald Trump and Senator Elizabeth Warren claim to agree on: restoring the Glass-Steagall Act. Senators John McCain and Bernie Sanders are on record in agreement, as well. This strange collection of bedfellows in support of reviving a depression-era law gives simultaneous reason for optimism and suspicion that restored legislation will be achieved.

The Glass-Steagall Act is the common reference to Sections 16, 20, 21, and 32 of the Banking Act of 1933, which separated commercial banking from investment banking. In particular, the Glass-Steagall Act:

prohibited banks that are members of the Federal Reserve System from underwriting any issue of securities (Section 16);

limited the directors and officers of banks from being directors and officers of securities companies (Section 32).

The separation of commercial banks and investment banks eroded over time and then was reversed in the Clinton Administration. The Financial Services Modernization Act of 1999, more commonly known as the Gramm-Leach-Bliley Act, repealed Sections 20 and 32 of the Glass-Steagall Act. That allowed for the creation of financial holding companies that offered an array of financial services through banking, securities, and insurance subsidiaries.

Some have argued the repeal of the Glass-Stegall Act and the creation of large financial holding companies contributed to the collapse of large banks, securities dealers, and insurance companies in 2008. The Senate Permanent Subcommittee on Investigations, for example, concluded that the changes to financial institutions after repeal “made it more difficult for regulators to distinguish between activities intended to benefit customers versus the financial institution itself.” As a result, repeal critics say, some large banks engaged in high risk investments with conflicts of interest and without adequate regulatory oversight.

Restoring the Glass-Steagall Act had been associated with liberal Democrats – like Senator Warren who introduced the “21st Century Glass-Steagall Act of 2015” in the 114th Congress – and non-traditional Democrats like Lyndon LaRouche. But the “21st Century Glass-Steagall Act of 2015” was co-sponsored by Republican Senator and former Presidential candidate John McCain. The 2016 Republican Party Platform supported “reinstating the Glass-Steagall Act of 1933 which prohibits commercial banks from engaging in high-risk investment.” Candidate Donald Trump blamed “lifting Glass-Steagall” as a primary cause of the financial recession and called for “a 21st century Glass Steagall.”

In theory, the Glass-Steagall Act could be restored based on what appears to be broad support across the aisle, with both sides claiming victory. A unified Republican government could attempt to restore it in the 115th Congress in order to appeal to the populist groundswell in the 2016 election. Restoring the Glass-Steagall Act could be offered as a compromise to placate Democrats for deregulating other aspects of the financial services sector.

As a practical matter, in spite of the bi-partisan election year support for restoring some form of the Glass-Steagall Act, there are good reasons for skepticism.

Separating commercial banks from investment banks would require significant government intervention and regulation of the financial services market. That degree of intervention and regulation is opposed to other pervasive Republican-led efforts to reverse the perceived over-regulation of banks. The call for “reinstating the Glass-Steagall Act” in the Republican Party Platform appears in a section on the “quiet tyranny” of federal regulation that “hamstrings American businesses and hobbles economic grown.” If the Volcker Rule is too much regulation for the Republican majority, then it is hard to see how a 21st Century Glass-Steagall Act could succeed.

The largest and most powerful banks and companies in the financial services sector oppose restoring the Glass-Steagall Act. The financial institutions most affected by restoring the Glass-Steagall Act are the largest banks in the United States, which have grown larger during and emerging from the recent financial crisis. President-Elect Trump currently is forming a cabinet and enlisting the help of strategic advisors from among investment bankers and Wall Street executives whose businesses benefited from the repeal of the Glass-Steagall Act.

Since the election and at the time of this post, there has been no mention of Glass-Steagall from the President-Elect, although he and his team continue to advocate dismantling the Dodd-Frank Act and federal regulations adopted during the Obama Administration. As a consequence, restoring the Glass-Steagall Act will likely remain merely a campaign promise.

This post is an in-depth follow up to Scott’s article “Trump Has Been Elected: What Next For Financial Services?” that ran in Bloomberg. The original article can be found here.

As the financial services sector and Republican politicians draft the obituary of the Dodd-Frank Act, it remains to be seen whether that landmark legislation will be survived by the Financial Stability Oversight Council (“FSOC”). Whether FSOC itself survives the advancing wave of deregulation, however, it seems increasingly likely that the FSOC’s reasons for existing will not.

Section 111 of the Dodd-Frank Act created the inter-agency FSOC, made up of the heads of eight independent financial regulators and chaired by the Secretary of the Treasury. In general, the FSOC is tasked with identifying and responding to risks to the financial stability of the U.S. financial system and with encouraging discipline in the financial services market. Like the Department of Homeland Security, the FSOC was created to centralize across federal agencies the analysis and response to financial security threats.

In particular, the FSOC was vested with the authority to determine whether a bank or nonbank financial institution with more than $50 billion in assets is subject to heightened regulation as a “systemically important financial institution” or “SIFI.” SIFIs are the latest incarnation of financial institutions that have long been called “too big to fail,” because they are critically important to our financial system.

In its short life, the FSOC has voted to designate four nonbank financial companies as systemically important: American International Group, Inc., General Electric Capital Corporation, Inc., Prudential Financial, Inc., and MetLife, Inc. In 2016, the FSOC voted to rescind that designation for GE Capital, since it significantly restructured itself over the past three years. Also in 2016, a D.C. federal district court overturned the FSOC’s designation that MetLife – the largest life insurance company in the United States – was a SIFI. The district court concluded that the FSOC’s designation was based on “fundamental violations of established administrative law” and therefore was “arbitrary and capricious.” That decision is now on appeal. As a result, only two nonbank companies remain in the category “systemically important.”

The FSOC also was empowered to designate financial market utilities (or FMUs) as systemically important. The FSOC has designated eight clearing services – such as the Clearing House Payments Company, the Chicago Mercantile Exchange, and the Depository Trust Company – as systemically important FMUs without incident.

House Republicans have criticized the FSOC as a “politicized” structure and part of a “‘shadow regulatory system’ that is both contrary to democratic principles and harmful to the U.S. economy.” Following the November elections, House Financial Services Committee Chair Jeb Hensarling claimed the FSOC is not “adding value to our economy” and as a result it should be tossed “in the trash bin.” “I do not believe any institution in America is too big to fail,” according to Representative Hensarling.

In the 114th Congress, House Republicans introduced legislation that called for:

limiting when the FSOC can designate a nonbank financial institution for heightened supervision;

allowing a financial services company to eliminate risk on its own rather than being designated “systemically important”;

making the FSOC subject to the traditional congressional budget and appropriation process; and

replacing the $50 billion threshold for bank SIFI designations with a multi-factor test.

Earlier this year, Representative Hensarling introduced the “Financial CHOICE Act of 2016,” which passed his Financial Services Committee and goes even further than his Republican colleagues’ other proposals. Among other forms of deregulation, the CHOICE Act would retroactively repeal the FSOC’s authority to designate nonbank financial companies as “systemically important.” Similarly, the CHOICE Act would retroactively repeal Title VIII of the Dodd-Frank Act, which gives the FSOC authority to designate financial market utilities as systemically important. In short, the CHOICE Act would legislate away the FSOC’s most important reasons for existing.

Representative Hensarling is preparing to introduce a revised version of the CHOICE Act (what he calls a “2.0 version”) early in the new Congress. Increasing congressional oversight and neutering the FSOC as a distinct regulator can be expected to be part of the legislation. Republican legislators will need to offer some concessions to Democrats in order to avoid a filibuster, but the regulatory power of the FSOC will hardly be seen as a grenade worth falling on for the Democrats. In spite of its important statutory mandate, the structure and authority of the FSOC is something only a Washington bureaucrat could love. At least for the FSOC, government regulation of institutions that are too big to fail has likely become too big to survive.

On October 11, 2016, the United States Supreme Court granted certiorari to a debt collection agency in its appeal from the Eleventh Circuit case Johnson v. Midland Funding, LLC.[1] In Johnson, the Eleventh Circuit affirmed its decision in Crawford v. LVNV Funding, LLC,[2] which held that a debt collector violates the Fair Debt Collection Practices Act (the “FDCPA”) when it files a proof of claim in a bankruptcy case on a debt that it knows to be time-barred. In view of the emerging circuit split, the Supreme Court agreed to hear the case in order to resolve two issues: (1) whether the filing of a time-barred proof of claim in a bankruptcy proceeding exposes a debt-collection creditor to liability under the FDCPA and (2) whether the Bankruptcy Code, which governs and permits the filing of proofs of claim in bankruptcy, precludes a cause of action under the FDCPA for the filing of a time-barred proof of claim in a bankruptcy proceeding.

In Johnson, which originated in the District Court for the Southern District of Alabama, plaintiff Aleida Johnson (“Johnson”) filed a Chapter 13 bankruptcy petition in March 2014. In May 2014, a debt collection agency—Midland Funding, LLC (“Midland”)—filed a proof of claim in Johnson’s bankruptcy proceeding for an amount of $1,879.71.[3] This debt accrued over ten years before Johnson filed for bankruptcy and its collection was time-barred by Alabama’s statute of limitations, which permits a creditor only six years to collect an overdue debt.[4] Johnson brought suit against Midland’s filing of the proof of claim under the FDCPA, which provides that “[a] debt collector may not use any false, deceptive, or misleading representation or means in connection with the collection of any debt.”[5] This prohibition encompasses an attempt to collect a debt that is not permitted by law.[6] Johnson argued that pursuant to the language of the statute, Midland’s time-barred proof of claim was “unfair, unconscionable, deceptive, and misleading in violation of the FDCPA.”[7]

Midland promptly moved to dismiss Johnson’s FDCPA suit. The District Court granted the motion to dismiss, finding that the Bankruptcy Code’s affirmative authorization for creditors to file a proof of claim—regardless of whether it is time-barred—was in direct conflict with the FDCPA’s prohibition on debt collectors filing a time-barred claim. Under the doctrine of implied repeal, the District Court found that the later-enacted Bankruptcy Code effectively repealed the conflicting provision under the FDCPA and precluded debtors from challenging that practice as a violation of the FDCPA in a bankruptcy proceeding.[8]

The Eleventh Circuit reversed the District Court’s decision, holding that “[t]he Bankruptcy Code does not preclude an FDCPA claim in the context of a Chapter 13 Bankruptcy when a debt collector files a proof of claim it knows to be time-barred. . . . [W]hen a particular type of creditor—a designated ‘debt collector’ under the FDCPA—files a knowingly time-barred proof of claim in a debtor’s Chapter 13 bankruptcy, that debt collector will be vulnerable to a claim under the FDCPA.”[9] Under the Eleventh Circuit’s analysis, the allegedly conflicting provisions of the Bankruptcy Code and the FDCPA could co-exist harmoniously, and the presence of a “positive repugnancy” between the statutes necessitating application of the un-favored doctrine of implied repeal was lacking.[10] Thus, although the Bankruptcy Code guarantees a creditor’s right to file a proof of claim they know to be time-barred by the statute of limitations, those creditors do not thereby gain immunity from the consequences of filing those claims.[11] The Court rejected Midland’s assertion that such an interpretation would effectively force a debt collector to “surrender[] its right to file a proof of claim.”[12] The court likened this scenario to filing a frivolous lawsuit, stating that “[i]f a debt collector chooses to file a time-barred claim, he is simply opening himself up to a potential lawsuit for an FDCPA violation. This result is comparable to a party choosing to file a frivolous lawsuit. There is nothing to stop the filing, but afterwards the filer may face sanctions.”[13] Accordingly, the Eleventh Circuit found that the FDCPA lays over the top of the Bankruptcy Code’s regime, so as to provide an additional layer of protection to debtors against a particular kind of creditor—debt collectors.[14]

The Court in Johnson makes clear that its holding is limited in scope and should not have far-reaching consequences for most creditors. Most importantly, the Court acknowledges that the FDCPA’s prohibitions do not reach all creditors—the statute only applies to “debt collectors,” which are a narrow subset of the universe of creditors that might file proofs of claim in a bankruptcy proceeding.[15] Furthermore, the FDCPA provides a safe harbor for debt collectors who unintentionally or in good-faith file a time-barred proof of claim.[16] Thus, a debt collector who files a time-barred proof of claim may escape liability by showing that the violation was not intentional and resulted from a bona-fide error.[17] These two limitations ensure that regardless of how the Supreme Court resolves this circuit split, there will not be a chilling effect on the submission of proofs of claims by the vast majority of creditors.

Although the direct impact of the Johnson ruling may be restricted to a limited creditor base, recent Supreme Court rulings involving bankruptcy cases have had broader knock-on effects on bankruptcy jurisprudence (and jurisdiction), and a decision on preemption as it relates to the Bankruptcy Code has the potential for a significant impact on various aspects of procedural and substantive bankruptcy law outside of the limited issue of the interplay of the FDCPA and the Bankruptcy Code. Accordingly, visit HHR’s Bankruptcy Report for future updates on this case and its potentially broader impact.

The Bankruptcy Code contains specific provisions that permit the subordination or disallowance of claims of insiders or others that may not, at equity, be entitled to the same status as a regular prepetition claim holder. For example, such claims may be equitably subordinated under section 510(c) or disallowed under certain subsections of section 502. In addition, some courts have held that section 105 affords bankruptcy courts authority to reorder the priority of claims, even if the provisions of the Code that permit subordination or disallowance would not otherwise apply. In such circumstances, Courts have recharacterized debt as equity investments, effectively subordinating the claims.

In a recent unpublished opinion, the Fourth Circuit Court of Appeals shed some light on the circumstances under which recharacterization of debt to equity may be appropriate. In In re Province Grande Old Liberty, LLC, Case No. 15-1669, 2016 WL 4254917 (4th Cir. Aug. 12, 2016), the debtor financed the acquisition of its principal asset, a golf and residential real estate development, through a loan from Paragon Commercial Bank (“Paragon”). The debtor subsequently defaulted on the loan and Paragon initiating foreclosure proceedings. In an effort to resolve the foreclosure proceedings, the debtor and Paragon entered into a settlement agreement pursuant to which Paragon agreed to sell its loan to a new company, PEM, at a significant discount. PEM was owned by insiders of the debtor and funded its purchase of the loan through a combination of equity contributions from its members and outside debt.

The debtor filed its bankruptcy petitions in the United States Bankruptcy Court for the Eastern District of North Carolina on March 11, 2013, and its petitions listed PEM’s claim at $7,000,000, which included the principal of the original Paragon loan (as opposed to the loan purchase price) and accrued interest. Two creditors of the debtor, seeking to increase recoveries on their own claims, initiated an adversary proceeding to have PEM’s debt equitably subordinated or reclassified as an equity interest in the debtor.

The bankruptcy court granted summary judgment in favor of the creditors, concluding that PEM’s loan purchase was, in effect, a settlement and satisfaction of the Paragon loan and that the portion of the loan purchase price funded by equity contributions should be recharacterized as equity. The effect was to invalidate PEM’s claim for the principal amount of the loan originally owed to Paragon.

PEM appealed the bankruptcy court’s order to the United States District Court for the Eastern District of North Carolina, which affirmed the bankruptcy court’s judgment. PEM then filed an appeal to the Fourth Circuit Court of Appeals.

The issue before the Fourth Circuit was not one of first impression — the Fourth Circuit had long recognized that a bankruptcy court’s equitable powers include “the ability to look beyond form to substance,” and had previously articulated the factors to consider in evaluating a request for recharacterization. See Fairchild Dornier GMBH v. Official Comm. of Unsecured Creditors (In re Official Committee of Unsecured Creditors for Dornier Aviation (North America), Inc.), 453 F.3d 225 (4th Cir. 2006).

In Dornier Aviation the Fourth Circuit held that in evaluating whether a debt claim should be recharacterized as equity, the court must evaluate: (1) the names given to the instruments, if any, evidencing the indebtedness; (2) the presence or absence of a fixed maturity date and schedule of payments; (3) the presence or absence of a fixed rate of interest and interest payments; (4) the source of repayments; (5) the adequacy or inadequacy of capitalization; (6) the identity of interest between the creditor and the stockholder; (7) the security, if any, for the advances; (8) the corporation’s ability to obtain financing from outside lending institutions; (9) the extent to which the advances were subordinated to the claims of outside creditors; (10) the extent to which the advances were used to acquire capital assets; and (11) the presence or absence of a sinking fund to provide repayments. Id.

In Province, the bankruptcy court weighed these factors and found that all of them weighed in favor of recharacterization. In particular, the bankruptcy court emphasized certain facts, including that (1) the agreement to settle the Paragon loan was a settlement agreement and was entered into “in settlement of the loan,” (2) PEM was not a signatory to the settlement agreement and was not involved in negotiations of the agreement; instead the Debtor’s principals negotiated the settlement agreement and note purchase on behalf of PEM and Paragon believed the Debtor’s principals had the authority to bind PEM, (3) the failure of the Debtor and PEM to observe any formalities regarding loan repayment and (4) the identify of interests between the Debtor and PEM. In its review, the Fourth Circuit reiterated the bankruptcy court’s findings and held that “the bankruptcy court properly ‘looked beyond form’ to determine that the ‘substance of the transaction’ was in fact the settlement agreement in which the Debtor used PEM as an extension of itself to complete what was, in effect, a satisfaction of the Paragon loan.” Province, 2016 WL 4254917 at *3.

The Fourth Circuit decision is notable however, because it dispensed of a specific challenge to the bankruptcy court’s decision. Namely, PEM contended that the bankruptcy court misapplied the Dornier factors by applying them to the wrong transaction. PEM argued that the bankruptcy court should have limited its analysis to the inception of the Paragon debt, rather than to the later settlement agreement. The Fourth Circuit disagreed, noting that “[t]he recharacterization decision itself rests on the substance of the transaction” involved.” Id. citing Dornier, 453 F.3d at 232 (emphasis in original). In Province, the Fourth Circuit concluded that the settlement agreement was the “substance of the transaction,” notwithstanding the fact that PEM was not a signatory to the agreement, because it was the basis of the note purchase and gave rise to PEM’s claims. In this respect the Fourth Circuit’s decision in Province is particularly noteworthy as precedent for a court evaluating recharacterization to look beyond the facts giving rise to the underlying claim and ultimately to the economic substance of the entire context of the transaction, even if the creditor whose claim is at issue was not a party to all components of that context.

In order to be retained to provide bankruptcy services to a debtor, most professionals generally need to satisfy the “disinterestedness” requirement of Bankruptcy Code Section 327(a). Typically, in order to be “disinterested,” among other things, the professional in most cases cannot be a creditor of the debtor, have outstanding invoices, at the time of the chapter 11 filing. However, despite this general requirement, a recent memorandum opinion in the U.S. Bankruptcy Court for the Eastern District of North Carolina (Greenville Division) leaves open the door for the possible post-petition payment of pre-petition amounts due to a professional.

In Gunboat International, Ltd., the Bankruptcy Court previously held that counsel may provide post-petition services, be retained under Bankruptcy Code section 327(a) and be considered “disinterested,” while still retaining an approximately $12,000 pre-petition claim. The Court directed that the pre-petition fees and expenses due be included in the professional’s fee application at which time there would be an opportunity to object to any amounts that did not specifically relate to the chapter 11 filing.[1]

Subsequently, the U.S. Bankruptcy Administrator, the North Carolina equivalent of the Office of the United States Trustee, objected to the counsel’s request as to these pre-petition fees and expenses because many of the time entries supporting the request did not relate to specifically preparing the chapter 11 petition or related first-day motions. The Bankruptcy Court disagreed, finding that preparing a chapter 11 case does not merely relate to “physically preparing initial forms and motions.” It applied a “logical and temporal nexus interpretation” as to whether pre-petition claims may be retained and paid while still preserving “disinterestedness.” It found that all amounts requested in the pre-petition invoice fell within this nexus.[2] The Bankruptcy Court then determined that the pre-petition fees and expenses were entitled to administrative priority under the Bankruptcy Code. However, the Bankruptcy Court sternly warned that it was not “condoning bankruptcy attorneys routinely filing petitions prior to being paid for pre-petition services” and that was not the “preferred practice.”[3]

While this Bankruptcy Court’s decision may provide a lifeline to professionals who are left with unpaid invoices prior to a bankruptcy filing, Gunboat has yet to be applied in the busy restructuring courts in Delaware and New York.

On July 6, 2016, the House of Representatives passed the Financial Institution Bankruptcy Act of 2016 (“FIBA”) as part of a larger financial services budget bill. FIBA proposes to amend the Bankruptcy Code (the “Code”) to address the specific challenges that arise when a financial institution becomes insolvent. The House Judiciary Committee’s report accompanying the bill concluded that, the bankruptcy process is not optimally designed for the orderly resolution of financial institutions. The Committee noted that the interconnectedness of financial institutions creates a potential for systemic risk to the broader financial markets, and, as was evident during the 2008 financial crisis, taxpayers are often called upon to prevent such risks. FIBA, which would be located under a new subchapter V within Chapter 11 of the Code, confronts these challenges by seeking to improve the administration of financial institutions’ bankruptcy proceedings.

Legislative Background

FIBA is the culmination of a bipartisan process that solicited and incorporated the recommendations of industry participants, regulators, and leading experts. Initially introduced and first passed in the House of Representatives in 2014, it failed to secure Senate approval. Its chief sponsor, Representative David Trott, reintroduced FIBA in the 2015 House session, where it was subsequently referred to the House Judiciary Committee. Following a hearing in July 2015, the House Judiciary Committee approved it by unanimous vote on February 11, 2016. FIBA was then brought to the House floor under suspension of the rules, which requires a two-thirds vote for passage and allows no floor amendments. On April 12, 2016, the House passed FIBA by voice vote. On July 6, 2016, the House passed a larger financial services budget bill, which included FIBA along with other regulatory provisions (such as congressional oversight of the Consumer Financial Protection Bureau).

Provision

a. Covered Financial Corporation

FIBA applies to Chapter 11 cases concerning “covered financial corporations”—corporations either incorporated or organized under any federal or state law as bank holding companies, or corporations that exist for the primary purpose of owning, controlling and financing their subsidiaries, that have total consolidated assets of $50 billion or greater, and whose annual gross revenues meet specified tests.

b. Speedy Transfer of Assets

The legislation allows a debtor holding company that sits atop a financial institution’s corporate structure to transfer the operating assets of the financial institution over the course of a weekend, enabling the financial institution to “continue to operate in the normal course, which preserves the value of the enterprise for the creditors of the bankruptcy without a significant impact on the firm’s employees, suppliers, and customers.”[1] The debt, any remaining assets, and equity of the holding company would remain in the bankruptcy process and would absorb the financial institution’s losses.

Furthermore, the financial institution’s operating subsidiaries would remain out of the bankruptcy process, which would help multinational firms that might also need to comply with multiple, and potentially conflicting, insolvency regimes in other jurisdictions.

c. Appointed Judges

FIBA recognizes that the presiding bankruptcy judge must be comfortable overseeing cases involving financial institutions. Therefore, the judicial process of a subchapter V case would be presided over by a bankruptcy judge randomly chosen from a pool of ten bankruptcy judges selected by the Chief Justice of the Supreme Court based on their experience, expertise, and specialized knowledge of financial institutions. In addition, a three-judge panel of Court of Appeals judges also appointed by the Chief Justice would preside over appeals.

d. Systemic Risks

To account for the potential for systemic risk in a subchapter V case, FIBA gives key financial regulators standing to present their views on pending motions to the presiding bankruptcy judge. The legislation also allows the bankruptcy judge, before issuing a final judgment on any motion, to consider the impact of a decision on financial stability in the United States.

e. Automatic Stay

The Code currently contains exemptions for counterparties to derivative and other structured transactions, allowing them to collect on outstanding debts from institutions in insolvency proceedings, ahead of other general creditors who must wait until a Chapter 11 plan is approved. FIBA overrides these exemptions by imposing a 48-hour automatic stay that would allow for the effective transfer of the financial institution’s operations to a bridge company.

Without this exemption override, counterparties to derivatives and similarly-structured transactions could terminate their relationships with a financial institution debtor upon the commencement of a bankruptcy case, likely endangering the successful transfer and continued operation of the bridge company and potentially threatening other entities within the broader financial system.

f. Timing

Taking into account the fact that the bankruptcy of a financial institution must be resolved expeditiously to mitigate the exposure of risk to financial markets, FIBA includes specific timeframes for the commencement of a case and court approval of the transfer of assets to the bridge company.

Conclusion

The purpose of FIBA is to establish a transparent and predictable bankruptcy process for large financial institutions. The legislation aims to prevent a situation similar to the 2008 financial crisis where, due to fears that the failure of financial firms could cause severe harm to the overall economy, the federal government provided taxpayer-funded assistance to prevent certain financial firms from failing. FIBA seeks to ensure that shareholders and creditors of a financial institution, and not taxpayers, bear the risks and losses of a failed financial institution. The legislation will proceed to the Senate for consideration.

In May, we reported on the judicial rescission of MetLife’s designation as an entity “too big to fail,” and noted that the court’s decision provided designated companies with a framework to challenge their designation. Another effective option is to fundamentally change the nature of the business, which is what GE Capital Global Holdings, LLC (“GE”) has done over the past three years. As a result, on June 28, 2016, the Financial Stability Oversight Council (“FSOC”) determined that GE is no longer too big to fail and released GE from the heightened regulatory standards and oversight imposed upon designated entities. This is first time FSOC has released an entity from the “SIFI” designation.

Three years ago, the FSOC identified GE as a systemically important institution whose failure would pose a threat to the country’s financial stability and accordingly, would be subject to a heightened level of regulatory scrutiny, additional capital requirements, and other government oversight. In response, however, GE transformed itself. Working with FSOC staff to assure that its changes would result in a rescission as part of FSOC’s annual reevaluations of GE’s status, GE made deliberate and significant changes to its business to minimize the risk to the U.S. economy. Its efforts included detangling itself from various financial markets, divesting business lines, and significantly restructuring its operations and corporate structure. In March 2016, GE requested that FSOC rescind its designation. Three months later, the FSOC agreed. Now, only two non-financial institutions remain SIFIs, and experience has proven two paths to de-designation: direct legal challenge or substantial, targeted business restructuring.

FSOC’s rescission of GE’s designation provides some insight into what factors matter most for liberating a company from the designation’s enhanced standards. One takeaway is that it matters not just to reduce the size of the organization, but how that reduction minimizes potential threat to the country’s financial stability. FSOC found that GE had “fundamentally changed its business” and become a “much less significant participant in financial markets and the economy.” GE’s march to de-designation tracked the core areas of risk that FSOC identified when it first designated GE as too big to fail:

In 2013, GE had total assets that exceed $549 billion; now, it has divested more than 50 percent of those assets, while at the same time nearly tripling the percent of its liquid assets.

GE was once the most substantial player in the commercial paper market; now, its presence is nominal.

At one point, distress at GE could have caused money market funds to buck the dollar; now, no money market funds hold GE commercial paper, eliminating that risk.

GE once had lines of credit at over fifty banking institutions; now, GE has just a single line of credit to its parent, significantly reducing its direct interconnectedness with large financial institutions (though the parent has lines of credit at over forty banks).

GE’s financing operations had touched over 56 million consumers and businesses; now, its financing transactions relate only to its industrial activity (e.g., aircraft-related lending).

GE’s corporate structure was so complex that distressed restructuring would have been virtually impossible, with the ability to maintain going concern value sacrificed; now, GE has a simplified corporate structure that would lend itself to distressed restructuring, if necessary.

All this is not to say that GE is small, by any means: the FSOC reiterated that GE remains a substantial and complex market participant. The focused yet substantial shift in the nature and scope of GE activities, however, has extricated GE from SIFI status and will allow it to continue to sharpen its focus on its core industrials business.

Yesterday, the Supreme Court granted certiorari in Czyzewski v. Jevic Holding Corp (“Jevic”). As previously reported, Jevic addressed whether a bankruptcy court can approve a settlement agreement that provides for distributions that violate the absolute priority rules as part of the structured dismissal of a chapter 11 proceeding. The Third Circuit held that such structured dismissals were appropriate even when they provided for distributions that do not strictly comply with the Bankruptcy Code’s absolute priority schemes. The Third Circuit’s ruling is consistent with the Second Circuit’s holding in In re Iridium Operating LLC,[1]which held that such structured dismissals may be appropriate if they are justified by other factors, but put the Third Circuit in conflict with the Fifth Circuit, which held in Matter of AWECO, Inc.[2]that it was inappropriate to approve a structured dismissal that did not strictly comply with the absolute priority rule. The Supreme Court will now address this circuit split and decide whether the flexibility offered to debtors (and some creditors) by structured dismissals outweighs that impact that such dismissals can have on the rights of other creditors and interested parties as discussed in our prior post. The Supreme Court’s decision may also have a broader impact on non-priority distributions more generally and could affect the permissibility of “gift plans,” which are similar to the structured dismissals in Jevic as they often provide for secured or senior creditors to make payments to junior creditors in order to garner support for chapter 11 plans. Check back with the HHR Bankruptcy Report as we continue to cover the briefing, developments, and potential impact of Jevic.

Last summer, the HHR Bankruptcy Report analyzed the Third Circuit’s ruling in Official Committee of Unsecured Creditors v. CIT Group/Business Credit Inc. (In re Jevic Holding Corp.),[1]which approved, as part of the structured dismissal of a chapter 11 proceeding, a settlement agreement that allowed distributions that violated the absolute priority rule. Following the Third Circuit’s ruling, the aggrieved priority creditors filed a writ of certiorari in the hope that the Supreme Court would address the split between the Courts of Appeals as to whether settlements must follow the absolute priority rule.[2] Now, in response to an invitation from the Supreme Court, the Solicitor General has submitted an amicus brief on behalf of the United States encouraging the Court to grant certiorari and to overturn the Third Circuit’s ruling.

The United State government has a particular and somewhat unique interest in having the Supreme Court review the Third Circuit’s decision. Federal taxing authorities (e.g. the IRS) are granted either second priority or eighth priority claims by the Bankruptcy Code depending on whether the tax obligation arose pre or post-petition. Accordingly, the government recognizes a real danger that, as a result of the Third Circuit’s ruling, debtors could collude with junior creditors to “squeeze out” government tax claims with a higher priority.

At issue in Jevic was the approval of a settlement agreement between the debtor, the Unsecured Creditors’ Committee and defendants to fraudulent transfer actions, that provided, in part, for (i) distributions to certain administrative and unsecured creditors as part of a structured dismissal of the chapter 11 proceeding, but did not provide for (ii) distributions to the debtor’s former employees who held higher priority claims arising from WARN Act liability. The former employees objected to the approval of the settlement on the ground that a bankruptcy court cannot approve a settlement and related structured dismissal of the case that does not comply with the order of priorities set out in section 507 of the Bankruptcy Code. Relying on the fact that it was highly unlikely that the debtor would confirm a plan of reorganization or that the employees would receive any distribution in a chapter 7 liquidation, the Third Circuit rejected the employees’ argument and held that a chapter 11 proceeding may be resolved, in rare circumstances such as those presented in the Jevic proceeding, through a structured dismissal that deviates from the Bankruptcy Code’s priority scheme.

The Solicitor General argued in his amicus brief that the Third Circuit had erred in reaching its holding for a number of reasons. First, the order of priorities established by the bankruptcy code reflects Congress’s detailed balancing of the rights and expectations of various creditor groups, and that by approving a settlement that deviated from this order of priorities, the bankruptcy court was upending “that carefully balanced system.” The Solicitor General noted that this outcome was particularly incongruous when compared to the requirements for chapter 11 plan confirmations and chapter 7 liquidations where priority creditors must be paid first (unless they consent to impairment). Second, the Solicitor General disagreed with the Third Circuit’s reasoning that a deviation from the Bankruptcy Code’s priority scheme was justified by the fact that the employees would not be prejudiced by the settlement because there was no prospect of a chapter 11 plan being confirmed or of a distribution to priority creditors if the case was converted to a chapter 7 liquidation (i.e. the employee creditors would be in the same position whether or not the settlement was approved). The Solicitor General noted that if the case had “simply been dismissed” pursuant to section 1112 of the Code, the employees could have pursued a fraudulent –conveyance action against the settling defendants on a derivative basis as creditors of Jevic. So rather than being outcome neutral, the employee creditors were being directly deprived of a potential source of recovery. The Solicitor General also argued that granting certiorari was appropriate in this case because of the existing split between the Circuitx on this issue, as well as the real and significant impact the ruling could have on the rights of creditors in future proceedings.

The Solicitor General’s amicus brief highlights the potentially wide impact of the Third Circuit’s ruling, despite the court’s attempt to limit its holding to cases where “specific and equitable grounds” justify deviation from the priority scheme. It is conceivable that in nearly every case where a debtor is administratively insolvent, a justification could be found for deviating from the absolute priority rule under the Third Circuit’s ruling. In those circumstances, debtors will be able to apply strong bargaining pressure on priority creditors to accept reduced claim amounts, less the debtor strike a settlement with other junior creditors of the case that cuts out the recalcitrant priority creditor entirely. Additionally, in light of the Circuit split on the issue, the Third Circuit’s ruling raises forum shopping concerns, as debtors (many of whom are organized under the laws of Delaware) will be more likely to commence proceedings in the Delaware bankruptcy court, if only to ensure themselves the benefit of the debtor-friendly rule adopted by the Third Circuit.

Check back with us in the future as we will to continue to cover developments in Jevic.

[2]Compare In re AWECO, Inc 725 F.2d 293 (5th Cir 1984)(finding that a bankruptcy court abuses its discretion in approving a settlement agreement that does not comply with the absolute priority rule); with In re Irdium Operating LlC, 478 F.3d 452 (2d Cir. 2007) (holding that a settlement may deviate from the absolute priority rule in certain circumstances).

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